Short-term Investment Options for Treasurers
The strong economic growth of the last decade has swollen corporate cash balances to record levels. Cash on S&P 500 company balance sheets alone grew six-fold in 1996-2006 to £600bn.1 With surplus cash at these volumes, corporate treasurers need to take time consider whether their reserves are efficiently invested and properly diversified.
The wide range of short-term investments available to treasurers can initially appear daunting and complex. In fact, instruments group into a few key types. Between them, these investments can offer a wealth of choice in terms of investment term, interest-rate profile and credit rating.
Once a treasurer is familiar with the options open to them, he or she can start to determine a suitable investment strategy based on their organisation’s requirements for security, liquidity and yield (see box below).
Questions to ask when determining an appropriate investment strategy:
Investment options can broadly be classified by their maturity. Money market instruments offer’near-cash’ returns with maturities ranging from overnight to two years (although most institutions generally access them for borrowing/investing up to one year). Interest rates may be variable/floating or fixed. The bond markets starts at maturities of two-years-plus but can stretch to 30-40 years or more, and focuses principally on fixed rates of interest.
In this article, we are concentrating on short-term investments issued and traded in the international money markets. There are thriving and highly developed markets in the sterling, eurozone and US dollar areas (and other markets) for all instruments detailed below, so treasurers have plenty of scope to build an appropriate investment strategy whichever jurisdiction(s) they operate in.
Table 1: Comparison of Short-term Investments
| Commercial paper (CP) | Asset-backed commercial paper (ABCP) | Certificates of deposit (CDs) | Government paper (T-bills) | Floating-rate notes (FRNs) | Repurchase agreements (Repos) | |
|---|---|---|---|---|---|---|
| Maturity | Overnight-270 days (typically <45 days) | Overnight-270 days (typically <45 days) | 1 day – 2yrs | 4 wks-52wks | Variable | Wholly negotiable |
| Issued by | Corporates | Corporates | Banks | Governments and public bodies | Corporates and banks | Corporates and financial institutions |
| Interest rate | Fixed | Fixed | Fixed** | Fixed | Variable | Negotiable |
| Interest paid | On maturity* | On maturity* | During term/on maturity** | On maturity** | During term or at maturity | On maturity |
| Secured | No | Yes | No | No | Yes /No | Yes |
| Access to capital before maturity | Sell on secondary market | Sell on secondary market | Sell on secondary market | Sell on secondary market | Sell on secondary market. Periodic refixing dates | Negotiable |
*Via the security being issued at a discount to face value; **variable rates may be available on issues of 1 year+ maturity
Commercial paper (CP) refers to tradable promissory notes (effectively IOUs) issued by companies (as opposed to banks). Maturity can range from overnight to 270 days – but most paper issued matures in less than 40 days.
CP does not usually pay interest during its life. Instead it is issued at a discount and the face value is paid at maturity. The yield is therefore a factor of the difference between the two over the term.
CP can be traded on the secondary market if investors need access to their capital before maturity; however most paper is selected for a specific maturity held for the full term.
Unsecured CP tends to be highly liquid and the broad range of maturities on offer allows investors to target their investment term very precisely. Investors can diversify risk by investing in issuers across different industries and sectors of the economy. Both Europe and the US have highly developed CP markets, which also offers opportunities for geographic diversification.
Standard CP is unsecured against any particular asset. Therefore most investors will want to ensure they invest in highly rated individual issuers and set strict counterparty limits. A growing proportion of CP is now asset-backed.
This has most of the features of standard CP above. Asset-backed commercial paper (ABCP) is secured against specific assets – usually short-term trade receivables from a company or a range of companies.
ABCP may be classed as’single seller’ where paper is backed by assets from a single institution or multi-seller where assets are purchased from a number of them.
ABCP promises more security than standard CP. Investors’ interests are protected by some form of credit enhancement. In addition, liquidity support from a sponsoring bank will allow timely repayment at maturity.
The more complex structure of asset-backed paper can make it harder to appraise and requires specialist credit-monitoring. However, investors tend to be rewarded for this extra complexity with a moderately higher rate of return than standard paper. Frequent, high-quality investor reporting – in an easily useable format – is an important factor. Without sufficient information, ABCP liquidity may suffer in times of uncertainty and so specialist knowledge of structures is invaluable.
Certificates of deposit (CDs) are effectively term bank deposits that can be traded on the secondary market prior to maturity. Terms can range from under one month to over two years.
CDs usually pay a fixed coupon on maturity – although longer-dated issues (e.g. 1 year+) may pay a variable rate
Because CDs are issued by banks, some investors can feel more comfortable with them than, say, commercial paper issued by a company whose creditworthiness comes under less regulatory scrutiny.
CD markets tend to be highly liquid, with the issuing bank often willing to repurchase certificates prior to maturity, enabling investors to liquidate their investment easily. However, this should never be assumed and investors should always determine that a market or issue is sufficiently liquid before investing.
CDs tend to be large-scale issues often requiring a high minimum investment. Bearing in mind the importance of retaining strict counterparty investment limits, this may put them out of the reach of smaller investors.
As well as issuing longer-term bonds, most governments also issue a range of short-term paper, generally referred to as treasury bills.
This is a liquid and highly active market with investors having the ultimate reassurance of a sovereign issuer. A variety of durations are generally available, depending on a government’s borrowing requirements, allowing investors to match their liquidity requirements very closely.
The security of government paper means it doesn’t need to offer much relative yield to attract investors, and returns will tend to be lower than other instruments of the same maturity. Higher yields may be available by investing in paper from lower-rated countries, assuming currency risk can be hedged.
Floating rate notes (FRNs) sit at the longer-end of the money market maturity spectrum with tenors typically of one year or longer.
FRNs pay a regular coupon as well as the promise of return of their face value on maturity. Issued by both banks and corporates, their name derives from the fact that the rate of interest is refixed periodically (the refixing date), based on a benchmark rate such as Libor or Euribor.
Some FRNs are issued with no maturity date and are known as perpetual FRNs. Investors can only regain their capital by selling these instruments on the secondary market.
The variable-rate nature of FRNs makes them very appealing in an uncertain interest rate environment when investors don’t want to lock themselves into a fixed rate. FRNs tend to offer relatively attractive yields. Moreover, the regular refixing of the coupon means they experience less capital volatility than fixed-interest securities. The creditworthiness of FRNs is generally straightforward to ascertain as they will tend to have a published credit rating, but independent analysis is always recommended.
As with fixed-rate bonds, the capital value of an FRN can fluctuate between interest-rate fixings to bring the security’s yield in line with the rest of the market. The bid to offer spread of a FRN tends to be wider than the other instruments detailed above and so regular trading can erode any yield advantage relatively quickly.
Like CDs, FRNs tend to be issued with fairly large minimum denominations. Smaller investors may be unable to achieve sufficient counterparty diversification by buying FRNs individually – in which case it may be more appropriate to access them via a liquidity fund.
Repurchase agreements (repos) are funding agreements set up between two parties. An investor buys a security from a counterparty bank then agrees to sell it back on a fixed future date, receiving back their principal plus interest.
Repos usually involve the sale and repurchase of government debt but the agreement can be based on any security. Any term can be chosen from overnight onwards, but repos are rarely agreed for periods of more than a year. Some repos are’open’ and have no maturity date. Instead either party can request to terminate the agreement on a day-by-day basis.
Because each repo is negotiated individually between two parties, there is plenty of scope to tailor a repo’s maturity and interest to each party’s requirements (although the rate of interest will generally be determined by market repo rates). Taking possession of the underlying security also gives the investor a high degree of comfort as this can be sold if the selling counterparty defaults (settlement risk).
While repos can be set up easily with standard, generic contracts, the investor needs to do a certain amount of ground work to determine, among other things, a fair price for the exchanged securities and the credit worthiness of the exchanged security. However, margin calls can be used if the repo price and the security’s market value diverge significantly. Negotiating a repo will incur costs and a custodian bank needs to be appointed to manage settlement and manage day-to-day administration such as valuation and margin calls.
Of course, understanding your investment options is only the first step in building an appropriate investment strategy using these various securities. Specialist guidance in appraising a security or issuer’s creditworthiness is advisable unless you are restricting investment to government securities. Published credit ratings are invaluable but some instruments will be unrated so proprietary in-depth analysis is sensible.
A portfolio needs to be constantly monitored to ensure interest-rate, currency and market risks remain within your agreed parameters. You also need to be sure that your chosen investments will remain sufficiently liquid whatever the market environment.
As well as benefiting from specialist investment advice, most of the investments detailed here will require the services of a custodian bank to hold the investment and handle settlement.
Unless your organisation has the scope to dedicate resources and specialist in-house expertise to selecting and managing investments, it may be more appropriate to access the instruments detailed above via a liquidity fund (money market fund) managed by a third-party asset manager. A liquidity fund will provide instant diversification across different instruments and issuers, so even small corporates can achieve a sufficient spread of counterparty risk.
The economies of scale of leading liquidity funds means they can achieve extremely keen trading terms (helping to ensure that yield isn’t eroded by active management of the underlying portfolio). Moreover, most liquidity funds offer same-day settlement, making them just as liquid as overnight deposits and they are credit-rated by some or all the leading rating agencies, which makes their risk profile relatively easy to appraise.
With legislation such as Basel II and MiFID allowing institutions greater scope to use AAA-rated liquidity funds instead of deposits, treasurers have more opportunity than ever before to ensure their surplus cash is appropriately invested.
1Source: Standard & Poor’s